The Securities and Exchange Commission (SEC) announced charges against a Louisiana-based hedge fund manager for defrauding investors of millions of dollars in mortgage-backed securities fraud scheme. Walter A. Morales and his firm, Commonwealth Advisors Inc., are accused of covering up massive losses that were suffered from investments associated with residential mortgage-backed securities during 2007 and 2008. The charges came after an SEC investigation that lasted more than four years.

Details of the Securities Fraud

According to the allegations, Morales and his firm made sure that the hedge funds they managed bought the lowest and riskiest collateralized debt obligation (CDO). Fittingly, Morales named this CDO “Collybus”, which is actually the official name of the smallest denomination of Athenian coin. Once Collybus was set up, Morales and Commonwealth sold residential mortgage-backed securities into the fund. The problem was that they sold these securities into Collybus at prices that were obtained four months earlier, knowing all the while that the residential mortgage-backed securities market had taken a huge financial hit.

As Commonwealth’s CDO investments began to reflect the market problems, instead of coming clean with investors, Morales instructed his employees to conduct more than 150 suspect trades between two hedge funds they managed. These trades were each at prices far below their own valuation for those securities. Morales, according to the SEC, also directed these trades in an effort to cover up a $32 million loss experienced by one of the funds in its Collybus investment. Not only did Morales lie to his investors about the amount and value of mortgage-backed assets in the hedge funds, he also created fraudulent internal documents to make the false valuations seem legitimate. In an even bolder move, these trades were ordered by Morales after Commonwealth had specifically stated (in forms filed with the SEC) that it would not execute trades between these hedge fund clients.

After the manipulative trades were completed, Morales allegedly directed one employees to mark the securities at fair market value. This act essentially created a fraudulent $19 million gain for the acquiring hedge fund, but that gain came at the expense of the funds which were sold. According the SEC’s allegations, when the suspicious trades peaked the concern of the prime broker, Morales fraudulently claimed the transactions were conducted for legitimate business purposes and were traded at current market prices.

The SEC also alleged that Morales lied to his biggest investor about its amount of exposure to Collybus funds. Morales had allegedly made an agreement with the investor to limit Collybus exposure through its investment in a specific Commonwealth hedge fund to just 10 percent of that fund’s equity. While the investor expected Morales to live up to his end of the bargain, he only abided by his word for a short time. By mid-2008, the investor’s exposure to Collybus funds had more than doubled. After the investor found out the deal had been broken and Commonwealth was not following the agreed upon valuation procedures, the investor asked for valuation committee meeting minutes. Fearing he would be discovered, Morales allegedly falsified documentation, describing meetings and valuations that never occurred. He then had the bogus committee meeting minutes delivered to the investor.

Commonwealth’s hedge fund clients included both pension funds and individual investors. Court documentation shows that the Municipal Employees Retirement System of Louisiana invested $44.2 million with three of Morales’ funds, along with the Firefighters Retirement System of Louisiana, who invested another $63.3 million with Morales’ company. As the mortgage markets began a severe decline during 2007, clients began taking extreme losses and bond rating agencies started to aggressively downgrade all sub-prime residential mortgage-backed securities.

Additional Securities Fraud Suit Filed

In addition to the SEC securities fraud lawsuit, several of the defrauded Commonwealth hedge fund investors filed their own civil suit. Among other things, that suit alleged Cantor Fitzgerald & Co., a New York-based investment bank, required Commonwealth to buy $740 million worth of inflated mortgage notes. In return for the purchase, Cantor Fitzgerald hired Commonwealth and Morales to manage over $1 billion of real estate assets. The investors’ civil suit was filed two years before the SEC securities fraud suit.

“Morales and Commonwealth Advisors concealed significant hedge fund losses from investors, including pension fund investors, instead of owning up to them and facing the consequences,” said SEC enforcement chief Robert Khuzami. “Investors put their fundamental trust in the hands of their investment adviser, and they deserve better than being manipulated and lied to through deceptive trades and phony documents.”

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